Wednesday, March 04, 2015

How fast is fast enough?

Growth is the single biggest determinant of startup valuations at IPO, as my fellow SaaS investor Tomasz Tunguz concluded based on an analysis of 25 IPOs in 2013. Growth (a.k.a. traction) is also the most important factor that attracts VCs and drives valuations in private financing rounds. Of course your team, product, technology, business model and market matter too, but when you’re past the seed stage the expectation is that these factors will have resulted in excellent growth. At the seed stage you can sell your story and vision. At the Series A and later stages, you have to back it up with numbers.

This isn’t surprising. Past growth tends to correlate with future growth, and since tech markets are winner-takes-all (or "winner-takes-most") markets, investors are obsessed about finding the fastest-growing player that has the biggest chance of dominating the market.

If growth is so crucial, how fast do you have to grow?

The answer depends on the market you’re in and the type of company that you want to build. If you’re in a small niche market – let’s say a business solution for a small vertical, localized to one country – maybe you don’t have aggressive, well-funded competitors. In that case it may be sufficient if you’re the fastest-growing player in that market, even if that means you’re growing only 20% year-over-year. There’s absolutely nothing wrong building a company like this, and you could end up with a highly profitable small business (or Mittelstand company). This is not the type of company VCs look for though, and the rest of this post is written based on the premise that you’re a SaaS startup that wants to grow to $100M in Annual Recurring Revenue (ARR).

So how fast do you have to grow in order to become a $100M company? Again using data compiled by Tomasz “Mr. SaaS Benchmarking” Tunguz we can see that the 18 publicly traded SaaS companies that were founded within the last ten years took five to eight years to reach $50M in revenues, with 14 out of the 18 being in the six to seven years range. (1) Add another one or two years for getting from $50M to $100M, and we can assume that most of these companies took seven to nine years to get to $100M.

$1M, T2D3, 50%?

If you want to get from 0 to $100M in revenues in seven years, your growth curve will likely look very roughly like this: Get to $1M in ARR by the end of the first year, triple to $3M in the next year, followed by another triple to $9M by the end of year three. Double your revenues in the next three years, so that you’ll reach $18M, $36M and $72M by the end of year four, five and six, respectively. Grow by another 50% in the next year and reach $108M in ARR by the end of year seven:

This is very much in line with the “T2D3” formula described by Battery Ventures in this TechCrunch post. If you want to give yourself nine years to get to $100M, your numbers will probably look roughly like this:

Could you also take the slow track?

The big question is now if this strong pattern is merely the result of investment bankers’ and public market investors’ preference for fast-growing companies or if something more fundamental is going on here. If there was a “law” which said that if you haven’t reached something close to $5M after three years, $10M after four years, and so on, you’ll likely never get to $100M, this would obviously have important implications for founders as well as investors.

My opinion is that there’s no hard law – in business you’ll find exceptions for every rule, and I think it’s definitely possible that software companies that grow slowly and eventually reach $100M exist. But I do think that the probability of ever getting to $100M does go down very significantly if you’re growing much slower than pictured above. This is because:

As companies get bigger, growth rates tend to go down, not up. So if your growth rate in year three is only, say, 50%, it’s unlikely that it will be 200% in the following year. It can happen and does happen, of course, but only if there’s a dramatic improvement in the business - a new product, a new distribution channel, a new business model or the like.

It’s hard for a slow-growing company to attract the best people. It’s not only about being “hot” as an employer (although that’s part of it, too). If you’re not growing fast, you’ll also have a hard time making compensation packages competitive with those of fast-growing companies. The positive feedback loop that is taking place here is very powerful: Momentum attracts talent and money, which you can turn into more momentum, and so on.

Not so many founders have the stamina and patience to stick to their company for 10, 12, 15 years - after so many years, many people understandably need a change. And while a company can of course survive its founders, it’s still a loss that doesn’t make things easier in the future.

Lastly, but maybe most importantly, if you can’t figure out a way to grow fast and you’re in a large market, chances are that someone else will. It also increases the chance of a new, innovative, fast-growing startup entering and possibly disrupting the market before you’ve reached significant scale.

Coming back to the original question, how fast is fast enough? If your goal is to eventually get to $100M in ARR, I think you should try to get there as fast as possible, and getting there by the end of year seven after public launch feels about right to me. This may seem like a very ambitious goal, but it would be boring if it was easy, wouldn’t it?

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(1) Note that there’s somewhat of an outcome bias in these results, as companies that were founded in the last ten years but take more than ten years to go public haven’t been included. So it’s possible that a few companies with slower growth will be added in the future, but that’s unlikely to change the picture significantly, especially if you keep in mind the trend which Tomasz has described in his post: SaaS startups are growing faster than ever before, and it’s taking them less and less time to get to $50M.